Stay Invested, Even Through The Drawdowns

Every investor has unique reasons for putting their money to work. Some are in the middle of their careers and want to save for retirement. Others have already retired and need a steady stream of income to maintain their lifestyles. And some are speculators who want to make as much money as possible in the shortest amount of time.

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While no two investors are exactly the same, they all share two broad characteristics. First, all investors seek to earn returns on capital. Second, all investors bear investment risk — the chance of loss — in exchange for the possibility of gain.

Little else better illustrates this risk than the Covid-related stock market crash that occurred in the first quarter of 2020, when the S&P 500 (NYSEMKT: VOO) tumbled more than 30%+ from its all-time highs in a matter of just six weeks. For many investors, these stomach-churning drops can be unsettling — or even panic-inducing. But is there any reason to worry when the market tumbles? And when it inevitably does, what should you do?

Image source: Koyfin

Drawdowns are fairly common

Luckily for investors, most drawdowns aren’t as sudden or severe as the Covid crash. Declines of more than 20%, like the one in March 2020, only occur about once a decade on average.

Instead, most drawdowns come in the much less dramatic form of pullbacks, or declines between 5% and 10% from prior all-time highs. These garden-variety drawdowns happen rather frequently, and it’s not uncommon to experience about three pullbacks per year. Corrections — deeper drawdowns that see markets decline between 10% and 20% from all-time highs — occur once or twice a year.

On the other hand, the most dramatic of drawdowns — declines of 50% or more — like those that occurred in the wake of the Global Financial Crisis of 2008, the 1970s recession, or during the Great Depression in the aftermath of the crash of 1929 — are far rarer. These significant financial crises have historically rocked markets just once every several decades.

However, even these seemingly disastrous crashes shouldn’t faze investors. Charlie Munger, Warren Buffett’s longtime investment partner and second-in-command at Berkshire Hathaway, puts it bluntly, noting that “if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get.”

Most drawdowns are just short-term noise

Munger may have been a bit harsh, but he’s got a point: drawdowns, even the big ones, aren’t anything to worry about.

Neurologist and investor William Bernstein endorses this view, arguing in his book Deep Riskthat there are really two types of risk, at least in a qualitative sense:

Shallow risk: “a loss of real capital that recovers relatively quickly, say within several years”
Deep risk: “a permanent loss of real capital”

While investors may understandably lose sleep over pullbacks, corrections, recessions, or once-in-a-generation declines, they all represent forms of shallow risk and are unlikely to have deleterious effects on terminal wealth — so long as one holds through the worst of it and refuses to sell.

On the other hand, what triggers deep risk isn’t the declines themselves — but ironically, investor behavior during those declines. Stock market investors who overreact to drawdowns and sell at inopportune occasions are far more likely to miss out on the subsequent recovery rally than the ones who sit still through the crisis and do nothing.

Tragically, it’s the investors who act in moments of panic to save their capital from perceived loss who are the ones most assuredly condemned to experience the ravages of deep risk. In the words of Fidelity Magellan Fund chief Peter Lynch, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

What’s the best thing to do during market drawdowns?

Fortunately, this means that preventing permanent capital impairment during drawdowns is simple: in times of crisis, do nothing — because if money is to be lost at all, it is far more likely to be lost by one’s own hands than by the force of market downturns.

Why?

Because the market won’t stay down forever. Recoveries will follow declines, bull markets will be birthed in the trough of bear markets, and sooner or later — in a few months, years, or decades — the market will again reach a new all-time high. And when it does, investors who held through the worst of it will look back and be glad they did.

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Ryan Sze holds no financial position in any of the companies mentioned. The Motley Fool owns and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.

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